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Abstract

The emergence of second generation biofuel industries will be heavily dependent on future prices of ethanol, which could incent landowners to switch land uses from agriculture to growing biofuel feedstocks. In this study, we investigate price levels of ethanol that will be necessary for landowners to grow hybrid poplar. In such an emerging industry, landowners will face a great deal of uncertainty and will consider options to change their production decisions over time. To address this uncertainty, we construct a real options model that considers the dynamic option for Canadian landowners to switch from agriculture to poplar plantations, and also the option to sell poplar plantations for ethanol or pulpwood. The uncertainty in prices for poplar is characterized by time series models of prices for ethanol and pulpwood that characterize price variability as a GARCH process, and reversion to the long term mean average prices. Uncertainty for the value of land allocated to agriculture is characterised by a geometric random walk. Given these price processes, the real options models suggest that current average price levels would have to increase by approximately 35% (i.e. by 0.21 $/L) if only ethanol is considered as an end product, but this increase may be reduced to 32% (i.e., to 0.19 $/L) if the landowner has options to sell the poplar to either ethanol or pulpwood producers. On low value agriculture lands, estimates suggest that an 18% increase relative to current ethanol prices (i.e., of 0.11 $/L) would be needed, which is approximately equal to the current second generation subsidies in Alberta.